Short Duration Income Strategy : Commentary

Portfolio Manager: Thomas Carney

As of 3/31/2016

The Short-Intermediate Income Strategy returned +1.50% (gross of fees), +1.34% (net of fees) in the first calendar quarter, compared to a +2.45% return for the Barclays Intermediate US Government/Credit Index (BIGC), our Strategy’s primary benchmark.  For the fiscal year ended March 31, 2016, the Short-Intermediate Income Strategy returned +1.45% (gross of fees), +0.81% (net of fees) compared to a +2.06% return for the BIGC. 
Our portfolio lagged the BIGC, in the past fiscal year given its purposefully defensive positioning (i.e., shorter average life and duration relative to the benchmark).  Overall portfolio metrics, as measured by maturity and duration, changed modestly compared to a year ago.  The average maturity of our Strategy decreased to 2.5 from 3.6 years, and the average duration was unchanged at 2.2 years.  These measures provide a guide to the Strategy’s interest rate sensitivity.  A shorter average maturity and duration reduces the Strategy’s price sensitivity to changes in interest rates (either up or down). 
The vast majority of Strategy investments contributed positively to results in the past fiscal year.  

Top Fiscal Contributors

Non-Convertible Corporate Debt Despite the credit spread widening highlighted above, the Strategy’s corporate investments performed well in the past year.  Key contributors in the investment-grade segment included the bonds issued by Kinder Morgan, Boston Properties, PetroLogistics, Markel Corporation and Equity Commonwealth.  Key non-investment grade contributors included the bonds issued by Rose Rock Midstream and Range Resources.  Overall, the Strategy’s corporate bond weighting increased a few percentage points from a year ago.  
US Treasury Notes – US Treasury Notes received a safe haven bid during the fiscal year marked by global economic uncertainty (primarily in China and other emerging markets) and increased market volatility.  Negative interest policies by other world central banks (notably the ECB and Japan) further aided the appeal of nominally small, but positive, US Treasury rates.  
Government Mortgage-Backed Securities (MBS) issued by Fannie Mae and Freddie Mac – Government MBS performed strongly in the past year, as government purchase activity remained strong through the Fed’s reinvestment of principal payments back into the MBS marketplace.  The result was tighter spreads and higher prices for MBS securities.  The Strategy’s MBS investments created from pools of high-quality, 15-year mortgages were key contributors to fiscal year results.  Our government mortgage investments, historically a key part of Strategy assets, are selected based on specific characteristics we believe mitigate the risks of prepayment, either too quickly or too slowly.  In exchange for the embedded prepayment risks inherent in MBS, we believe we’ve been adequately compensated by higher coupon income (and therefore overall return) than we could otherwise receive in comparable quality corporate bonds.  In the past year, the Strategy’s government MBS weighting declined slightly due to a lack of favorable investment opportunities.
Non-Agency Securitized Products (RMBS, CMBS, Auto ABS) – This segment of our portfolio continued to perform at or above our expectations with respect to credit performance and average life progression while providing steady income and minimal price volatility during the fiscal year.  Key contributors in this segment included the commercial mortgage-backed (CMBS) bonds issued by Rialto Real Estate Fund LP, the non-agency residential mortgage-backed securities (RMBS) bonds issued by Oak Hill Advisors Residential Loan Trust, and automobile asset-backed securities (auto ABS) bonds issued by Credit Acceptance Auto Loan Trust and Santander Auto Drive Receivables Trust.  

Top Fiscal Detractors

Select Convertible Corporate Debt and Redwood Trust Common Stock – The Strategy’s investment in Redwood Trust common stock (down 20.6%) and the company’s 2- and 3-year convertible bonds detracted from results in the past fiscal year.  Despite difficult market conditions over the past few years, a volatile interest rate environment and increased competition, Redwood has remained profitable in each of its business segments.  The company recently took meaningful steps to right-size its cost and business structure in light of market conditions.  The company remains competitively advantaged across its platforms and is well positioned to benefit from potential government-sponsored enterprise reform, the eventual revitalization of private-label residential securitization and future commercial investment opportunities.  We continue to view the company as a “value investor” in mortgages and mortgage securities that has a culture of prudence, a renewed focus on growth in per share value and great skills in credit risk assessment.  We believe that the market valuation of less than book value now overly discounts Redwood’s future earnings capabilities. While we wait for the value to be realized, a dividend yield of nearly 9% should enhance future total return.   
While we cannot predict the near-term direction of energy prices, we believe the financial distress being inflicted by currently low energy prices will likely lead to operational distress in the form of reduced oil and natural gas production. In other words, we believe the cure for low prices, is low prices. We are particularly optimistic about the long-term supply and demand outlook for US natural gas, and as such, our midstream and E&P investments are heavily weighted towards companies that produce and transport natural gas. Why natural gas and not oil? First, US natural gas prices are driven by domestic supply and demand, and they are not influenced by international forces such as OPEC. Second, at current prices, we believe natural gas production is set to plateau or fall, while natural gas demand is set to rise.
US Treasury notes US Treasury note yields rose (prices declined) as the Fed embarked on its process to “normalize” short-term interest rates by increasing the fed funds rate for the first time in nearly 10 years. Our Treasury holdings primarily consist of shorter-term treasury securities with an average maturity of slightly over two years.

Investment Activity

Despite portfolio metrics that were mostly unchanged on the year, it was a very active year for portfolio investment activity.  It’s typical that a quarter to a third of Strategy assets matures every year, given the Strategy requirement to maintain an average life within 2- to 5-years.  Last year was no exception.  Although base rates (US Treasury) generally trended lower during the year, we were able to deploy approximately $400 million of Strategy capital when Treasury rates temporarily trended higher and when credit spreads widened sufficiently (sometimes dramatically) to compensate for the embedded risks.  Examples include:
Corporate Bonds – Anheuser-Busch InBev Finance, 1.9% 2019 – Anheuser-Busch InBev is the leading global beer brewer and one of the world’s top consumer products companies.  The company is home to six of the top ten most valuable beer brands.  The company generates significant free cash flow, has a history of prudent capital allocation and intends to maintain a solid investment-grade rating.  These corporate bonds are an example of numerous investments the Strategy entered into during the past year.  Namely, investment-grade companies run by able capital allocators with bonds maturing in approximately two to three years.  In a low return world, we believe these roughly 3-year Anheuser-Busch bonds offer reasonable return opportunities (approximately 2 percent yield) with minimal credit risk.
Corporate Bonds – Energy Transfer Partners (Regency Energy Partners LP), 6.5% maturing in 2021, callable in 2016 – Energy Transfer Partners is one of the largest energy infrastructure companies in the United States.  They own and operate approximately 62,500 miles of natural gas and natural gas liquids pipelines.  Energy Transfer Partners operates like a toll road, receiving fees for gathering, processing, transporting and storing natural gas, while generally avoiding commodity price risk.  In addition, the company has a long history of being good stewards of capital, who have treated bondholders fairly and as partners in the business.  Yielding over 5 percent, our investment in the Energy Transfer Partners investment-grade bonds above is an example of the opportunities we’ve identified in the midstream infrastructure energy space in the past year. 
Structured Securities – Rialto Real Estate Fund LP (RIAL) Real Estate Liquidating Trust, 2.75% and 3.00% with average life of 0.8 years – Rialto is one of a series of commercial liquidating trust investments the Strategy has made since the third quarter of 2012.  Rialto is an institutional investor with a proven track record of resolving commercial real estate loans through economic cycles. Our investment represents an interest in pool of seasoned commercial loans purchased from a commercial bank at a significant discount to the estimated market value of the real estate collateral (located in a mix of geographies and tenant types).  Our credit analysis includes factors such as our investment’s senior claim on the loan pool’s cash flows, the historical performance of the loan pool, and Rialto’s equity position (“skin in the game”).  We believe this represents yet another example of finding and investing in high quality cash flows with low credit risk in a marketplace where few such opportunities exist. 

Fiscal 2016 Review

2016 jumped off to the most volatile start since 2009, as a selloff in China’s stock market sparked fears of a global growth slowdown or contraction.  Energy prices followed worldwide stock prices down the rabbit hole, with oil prices dropping nearly 30% in the first three weeks of the year.  By the time Fed Chair Yellen sat before Congress in early February, global markets were jittery enough to push the intraday 10-year Treasury yield down to 1.5% on the mere mention of the possibility of the US following other central banks (namely, the European Central Bank and Japan) in implementing negative interest rates.  Calmer heads prevailed, however, when US payroll data continued to show solid growth and resilience in the US economy.  By the end of the first calendar quarter of the year, stocks and oil rebounded meaningfully, as fears of recession receded. 
During the past fiscal year (March 31, 2015 to March 31, 2016), US Treasury bond yields continued their relentless march lower.  For example, 5- and 10-year US Treasury bond yields declined approximately 16 basis points each to 1.2% and 1.8%, respectively (a basis point equals 1/100 of a percent).  Declining interest rates resulted in price gains for existing bonds (bond prices and changes in interest rates are inversely related), adding to the coupon returns for most fixed-income investors, our Strategy included.
Corporate bonds and other credit sensitive securities underperformed Treasury bonds in the past year, as credit spreads (the incremental return investors demand above US Treasury bonds for owning corporate debt) widened, particularly for non-investment grade or high-yield bonds.  A broad measure of corporate bond spreads compiled by Merrill Lynch rose to 170 basis points as of March 31, up 34 basis points year over year.  The repricing of credit risk in the high-yield market was more pronounced, with spreads increasing by more than 200 basis points, or a full 2 percent.  While the overall marketplace remains expensive by historical standards (i.e., low absolute yield levels), last year’s credit repricing presented pockets of opportunity to invest favorably relative to ultra-low US Treasury rates.

Outlook

In spite of setbacks in certain areas of the credit markets (namely energy given the significant decline in commodity prices in the past year), bond investors continue to have the “wind at their backs,” thanks to the largesse of central banks worldwide.  Ultra-low interest rates in the US government bond market and negative interest rates in much of the remainder of the non-US sovereign bond world seem rather “absurd,” as Wally and Brad outline in their investor letter for this quarter.  Distortions of markets that defy conventional investing logic seem unlikely to end well–much like the creation of Frankenstein’s monster.  Therefore, we will continue to position the Strategy defensively relative to interest rate exposure, while we patiently seek out areas of opportunity like those mentioned above. We will invest one security at a time, relying on a fundamental, research-based investment approach and remain well positioned to take advantage of any market weakness. 


Contributions to performance are based on actual daily holdings. Securities may have been bought or sold during the quarter. Return shown is the actual quarterly return of the security. The holdings identified do not represent all of the securities purchased, sold or recommended for Weitz Inc.’s advisory clients. Contact Weitz Inc. to obtain the methodology for the calculations above. You may reach Weitz Inc. at 1125 S 103rd Street, Suite 200, Omaha NE 68124, at 1-800-304-9745 or at weitzinvestments.com.

Investors should consider carefully the investment objectives, risks and charges and expenses of the Strategy before investing. Past performance does not guarantee future results. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk.
Performance information in this letter is the weighted-average performance of accounts managed by Weitz Investment, Inc. (“Weitz Inc.”) under its Short-Intermediate Income Strategy (the “Strategy”). Performance of particular securities in this letter is shown for an entire time period. All other portfolio holdings information is for a particular “Representative Account” in the Strategy.

The returns above also include fee waivers and/or expense reimbursements, if any; total returns would have been lower had there been no waivers or reimbursements. Contributions to performance are based on actual daily holdings. Comparative returns are the average returns for the applicable period of the Barclays U.S. Government/Credit Index. Barclays U.S. Government/Credit Index is the non-securitized portion of the U.S. Aggregate Index and includes Treasuries, government-related issues, and corporates. Using standard rules-based index methodology and market capitalization weighting, these indexes accurately reflect the performance and characteristics of the underlying markets. Index performance is hypothetical and is shown for illustrative purposes only.
Investors should consider carefully the investment objectives, risks and charges and expenses of the Strategy before investing. Past performance does not guarantee future results. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk.